It’s essential to plan for things like your future needs. When considering that, it’s critical to invest now in financial resources to support you with retirement income late into life. There are more investment choices outside of real estate, savings accounts, and the stock market to consider. Employers can support employees by helping to answer their questions about 401(k) retirement plans, reinforcing the importance of long-term investing.
Employees may feel overwhelmed with considerations associated with participating in a plan. For example, they may be deciding how much to put aside. Or if they’re new employees, they may be transferring their existing account over when switching companies. It’s a world chock-full of jargon, and we’re here to break it all down for you and them.
1. What is a 401(k) plan, and why is it called that?
A 401(k) is a retirement savings plan: Cash taken out of your current payroll that will replace employment income when you’re ready to enter your next life stage. It’s named for the tax code section that governs it.
If you elect to contribute to your retirement plan, the percent you choose will be automatically deducted from your paycheck each pay period. This money is taken out before your paycheck is taxed (so more of it can go to your retirement instead of the government). The contributions are invested at your discretion into one or more investment options the plan provides, which can include but not be limited to exchange-traded funds (ETFs), index funds, or mutual funds (such as target-date funds that manage and reduce investment risk over a period of time based on when you anticipate retiring). The investments grow in your 401(k) account tax-free—as long as you don’t take a distribution.
2. What’s the employer’s role in my 401(k)?
Traditional 401(k) plans are set up and maintained by employers, which is why they’re also known as employer-sponsored plans. Employers offer matching contributions, meaning they’ll agree to contribute a set percentage of money to your plan if you also contribute a certain percentage of your salary (i.e., no more than a $23,000 salary deferral for 2024) within the income limit (i.e, $345,000 annual compensation in 2024). This can make the 401(k) especially worth it for employees.
Say your company has a 50 percent match policy, and you contribute six percent of your annual salary to your 401(k). Your company would then contribute three percent, and your total yearly contributions would be nine percent of your annual salary.
You should always maximize your employer’s match—it’s essentially free money, and it’s also safe from taxation while sitting in a 401(k) account (though it might be taxed upon distribution, depending on your plan type). However, whether or not your company offers a match shouldn’t deter you from regularly adding money to your 401(k).
3. Do all companies match 401(k) contributions?
Though matching contributions up to a certain percentage of an employee’s salary is common practice at larger companies, employers are not required to offer a company match.
A company has complete control over whether or not they do since the match is a form of profit sharing. Doing so offers some benefits, and organizations that match employee contributions can deduct them from their taxable income up to a certain amount. But if employers are not highly profitable or are going through tight financial situations, they may opt not to match the contributions.
4. Are all 401(k) plans created equal?
Not quite. Having these qualities can make a plan more advantageous than others:
- The ability to participate right away: Many companies require one to three months (or even up to a year!) of employment before workers qualify to join the retirement plan. The sooner you can participate and take advantage of any employer match, the better.
- A generous 401(k) match: The more you contribute, the more your employer will too. That’s just more money in your (retirement) pocket.
- Immediate vesting: You won’t get to keep your employer’s contributions to your 401(k) account until you are vested in the plan. Here, “vesting” means you own these contributions and can freely take them with you if you leave the company, for example. Many employers follow a vesting schedule that allows you to keep a more significant percentage of the contributions the longer you stay with them—and some companies require more time in service before you can keep the entire match provided.
- Low expenses or the company pays most fees: Fees are associated with establishing and maintaining 401(k) accounts, sometimes high fees. It’s great if you can work with an employer who is generous enough to cover (entirely or a reasonable margin of) these fees.
- Automation: Automatic enrollment, deductions, and filing will make your life much easier. Need we say more?
5. When do I need to start contributing?
The most important thing to know about 401(k)s is that the earlier you start working on one, the better. The more money you save now, the more your money will have grown by the time you need to use it, and the bigger the nest egg you’ll have to cuddle with when you go home at night.
Source: Federal Reserve Bank of St. Louis
6. How much should I contribute, and how often?
A generally accepted amount is 10 percent each pay period. However, you should invest as much as you feel you can afford if you want to maximize your retirement planning successfully.
That being said, consider other funds that require your financial attention: Make sure you have enough emergency funds and shorter-term savings, so you don’t have to borrow or use any of your 401(k) money before you retire (refer to question 10 for more on this). At the very least, attempt to contribute as much as your employer matches, since that is a guaranteed return on the match, whether 50 or 100 percent.
Keep in mind that throughout the year, you have the option to adjust your contributions per pay period. So if you need to play catch-up, you might decide to contribute up to 25 percent (depending on your salary—see the next question) for four months. Then, depending on your financial situation, you can reduce your contribution to the minimum your employer match requires.
7. What’s the maximum I can contribute?
There are annual contribution limits to how much you can add to your 401(k):
- In tax year 2024, you can contribute a maximum of $23,000.
- However, if you’re 50 or older, you can make an additional catch-up contribution of as much as $7,500 for a total of up to $30,500 (for tax year 2024).
These limits change annually to keep pace with inflation. Once you max out your contributions, you can still save for your retirement but must use alternative methods, typically a savings vehicle such as an Individual Retirement Account.
The Traditional IRA is funded with pre-tax dollars, and the Roth IRA with after-tax dollars. You can have both, but remember that contributions are aggregated (added together) for contribution limits. The IRA contribution limit is $7,000 for those under age 50 and $8,000 for those age 50 or older in 2024.
8. How is my 401(k) plan taxed?
Traditional 401(k) plans are tax-deferred—meaning you won’t have to pay taxes until you pull the money from your account. This can offer considerable tax advantages if your current bracket has a higher tax rate than your projected tax bracket when you reach retirement age.
As we touched on earlier, your 401(k) contributions and your employer’s contribution match, and the money you make in interest doesn’t get taxed while they’re in your traditional 401(k) account. When you decide to withdraw the money, expect to pay income taxes on that amount (and additional penalties if you take out your funds early).
Once you retire, the money you take from your 401(k) account—also known as a distribution—is seen as regular income in the eyes of the government. That money is subject to federal, state, and local income taxes. Plus, the full amount of your payroll taxes (aka Social Security and Medicare taxes) come payday. You’ll also pay income taxes when you withdraw your employer contributions, but not their share of payroll taxes.
Alternatively, you can use a Roth 401(k) to make contributions after tax. That makes it so you don’t pay taxes on your distributions. When choosing between the two, you need to decide if it’s better to take a tax break now or in the future, and may want to work with a financial advisor, such as an accountant or a Certified Financial Planner (CFP) for investment advice, depending on your financial goals.
9. What should I do with an old 401(k)?
You have a couple of options to weigh when leaving a company you’ve established a 401(k) with:
- Leave assets in your previous employer’s plan.
- Move the assets into a rollover IRA or a Roth IRA.
- If allowed, roll over the assets to a new employer’s workplace savings plan.
- Cash out or withdraw the funds (but if you’re younger than 59½ years old, we don’t recommend this route because of the additional penalties you’re hit with).
What you choose will depend on your current financial situation and your goals for your retirement plan. Be sure to evaluate the pros and cons of each option.
10. How long do I need to wait to use my money?
Typically, you can’t withdraw any of your retirement money before 59½ years (so specific!) without incurring a 10 percent early withdrawal penalty from the IRS on top of the income taxes you’d typically pay. This early distribution penalty is the cornerstone of the government’s campaign to discourage us from ravaging our savings before our golden years.
There are certain exceptions to the penalty if you need to withdraw before you reach the age of 59½. For instance, if you’re retiring from the company currently sponsoring your plan and are at least 55 years old, you can withdraw monthly income from your 401(k) with no penalty. However, you will owe income tax on the amount (your company’s benefits administrator can give you details).
Whatever your age, your employer must give you a summary plan description (SPD) annually and upon request, which will address early retirement options in your 401(k) plan. This option is unavailable if you roll over your 401(k) into an IRA.
Another way around the 10 percent withdrawal penalty is through a “series of substantially equal periodic payments,” also known as a Section 72(t) distribution. This option generally gives you the least retirement payout available and can be used by anyone with a 401(k) plan, regardless of age.
In a 72(t) withdrawal, the distributions must be “substantially equal” payments based on your life expectancy. Once the distributions begin, they must continue for five years or until you reach age 59½, whichever is longest.
11. How many plans can I have?
There’s no legal limit to the number of 401(k)s you can have at one time, but you can only contribute new money to the plan at your current employer. Therefore, keeping open 401(k) plans from previous companies usually doesn’t make sense. To simplify things, better monitor your investments, and maintain control over your accounts, it’s a good idea to consolidate old 401(k)s into your current 401(k) or an IRA.
12. What information will I receive to manage my 401(k)?
The federal government requires employers to provide 401(k) plan participants with the details they need to understand and manage their accounts. This is the SPD, as mentioned above, and is also typically included in an employee handbook. It offers answers to almost all of their 401(k) questions in plain English—no legalese here!
Your company’s SPD should include (but is not limited to):
- Information on how to get started, including the importance of naming a beneficiary
- Plan rules, eligibility requirements, vesting schedules, and other documents outlining the operation and management of the plan
- Details on how they can make changes to the paycheck deduction amount (and how long it takes to process those changes—e.g., one pay period or 30 days)
Some employers also provide their employees with the option to take out money from their retirement plan in the form of a 401(k) loan. This alternative to traditional loans differs from hardship distributions, which are only allowed when the employee is in dire financial straits and needs the money. If your company offers 401(k) loans or other benefits like contribution matching, these benefit details must also be included in the SPD.
Benefits plans typically evolve with the needs of its participants, and in time, your company may make changes to its 401(k) program as well. If this happens, employers must provide participating employees with a summary of the adjustments made, and how the changes may affect their retirement account. That is in addition to employers providing a new copy of the SPD annually, along with whenever employees request one.
